Andrew, Damitio, Schmidgall Financial Management for the Hospitality Industry ©2007 Pearson Education, Inc. Upper Saddle River, NJ Chapter 10 Other Project Valuation Criteria

Andrew, Damitio, Schmidgall Financial Management for the Hospitality Industry ©2007 Pearson Education, Inc. Upper Saddle River, NJ Objectives  Accounting Rates of Return  The Payback Criterion  The Internal Rate of Return  Calculating the IRR  Using the IRR for Valuation Decisions  Potential Problems with the IRR  Using Capital Budgeting Criteria: An Example  Accounting Rate of Return  Payback  Internal Rate of Return  Net Present Value  Additional Project Valuation Criteria

Andrew, Damitio, Schmidgall Financial Management for the Hospitality Industry ©2007 Pearson Education, Inc. Upper Saddle River, NJ Accounting Rates of Return (ARR) Often calculated by dividing average net income (or in some cases average cash flow) by the average book value of the investment in the project (for example, the average assets or average equity of the project over its life). ROA = Average Annual Income After Tax Total Investment Cost ROE = Average Annual Income After Tax Total Equity Investment Accounting rates of return are easy to calculate Normally based on accounting net income, not cash flow, Accounting rates of return do not account for the time value of money

Andrew, Damitio, Schmidgall Financial Management for the Hospitality Industry ©2007 Pearson Education, Inc. Upper Saddle River, NJ Maple City Hotel Project ROA = ($500,000 + $560,000 + $600,000 + $630,000)/4 =.095 or 9.5% $6,000,000 ROE = ($500,000 + $560,000 + $600,000 + $630,000)/4 =.286 or 28.6% $2,000,000 20X420X520X620X720X9 Total Equity Investment $2,000,000 Total Project Cost$6,000,000 Net Income$500,000$560,000$600,000$630,000

Andrew, Damitio, Schmidgall Financial Management for the Hospitality Industry ©2007 Pearson Education, Inc. Upper Saddle River, NJ Payback Criterion Payback is the number of periods, usually years, that a project takes to generate total cash inflows equal to the total cash outflows associated with the investment in the project. It represents the point in time (in periods) when the initial investment in the project is recovered. N ∑ NCF t = Initial Investment t =1 where N = Payback Period NCF t = Expected Net Cash Flow at Time t

Andrew, Damitio, Schmidgall Financial Management for the Hospitality Industry ©2007 Pearson Education, Inc. Upper Saddle River, NJ Suppose a $5,000 investment in a new oven will produce the following net cash flow stream: -$5,000 + $1,000 + $1,500 + $2,500 + $2,500 + $2, This project will have a payback of three years. NCF 1 $1,000 +NCF 2 + 1,500 2,500 + NCF 3 + 2,500 $5,000 = Initial Investment

Andrew, Damitio, Schmidgall Financial Management for the Hospitality Industry ©2007 Pearson Education, Inc. Upper Saddle River, NJ Advantages and Disadvantages of the Payback Criterion The payback is easy to calculate It ignores all cash flows occurring after the payback period It ignores the time value of money, at least in a precise sense Setting of the allowable payback period does offer a means, albeit crude, of adjusting for the riskiness of the project(s) under consideration

Andrew, Damitio, Schmidgall Financial Management for the Hospitality Industry ©2007 Pearson Education, Inc. Upper Saddle River, NJ Weaknesses of Payback Illustrated Based on the payback period alone, we would be indifferent between projects A and B in examples 1 and 2 below. Example 1 The payback method does not take into account cash flows beyond the recovery period and thus would not recognize the superiority of project B below. Project AProject B Cost of Project$ 12,000$ 12,000 Annual Cash Flow Year 1$ 4,000$ 4,000 Annual Cash Flow Year 2$ 4,000$ 4,000 Annual Cash Flow Year 3$ 4,000$ 4,000 Annual Cash Flow Year 4$ 0$ 5,000 Payback3 years3 years

Andrew, Damitio, Schmidgall Financial Management for the Hospitality Industry ©2007 Pearson Education, Inc. Upper Saddle River, NJ Weaknesses of Payback Illustrated (cont’d) Example 2 The payback method does not take into account the timing of cash flows and thus would not recognize the superiority of project A below (note that both projects generate the same total dollar value of cash flows, $ 6,000 but that project A receives more of those cash flows earlier and thus would have the higher NPV). Project AProject B Cost of Project$ 6,000$6,000 Annual Cash Flow Yr 1$ 3,000$ 1,000 Annual Cash Flow Yr 2$ 2,000$ 2,000 Annual Cash Flow Yr 3$ 1,000$ 3,000 Payback3 years3 years

Andrew, Damitio, Schmidgall Financial Management for the Hospitality Industry ©2007 Pearson Education, Inc. Upper Saddle River, NJ Internal Rate of Return (IRR) IRR is defined simply as the rate of discount that makes the NPV of the project equal to zero. Another way of saying this is that it is the rate of discount that makes the present value of the inflows equal the present value of the outflows. It represents the true compounded rate of return that a project generates IRR we calculate using the equity approach represents the true financial ROE n NPV = 0 =∑OCF t + τΔINT t - (ΔINT t + ΔPRIN t ) -EQ 0 t=1(1 + IRR) t IRR we calculate using this approach will represent the true financial ROA n NPV = 0 = ∑ OCF t - I 0 t=11+IRR) t

Andrew, Damitio, Schmidgall Financial Management for the Hospitality Industry ©2007 Pearson Education, Inc. Upper Saddle River, NJ Calculating the IRR Use a graph of the NPV profile Use trial and error Use a computer program like Excel Example: Time0 -$ 1,500,000initial investment 1$ 140,000net cash inflow 2$ 226,000net cash inflow 3$ 316,500net cash inflow 4$ 361,995net cash inflow 5$ 2,928,19net cash inflow

Andrew, Damitio, Schmidgall Financial Management for the Hospitality Industry ©2007 Pearson Education, Inc. Upper Saddle River, NJ Calculating the IRR (cont’d) CellAB 1NCFO NCF NCF NCF NCF NCF IRR Excel formula=IRR(B1:B6)

Andrew, Damitio, Schmidgall Financial Management for the Hospitality Industry ©2007 Pearson Education, Inc. Upper Saddle River, NJ A Typical Project Net Present Value Profile

Andrew, Damitio, Schmidgall Financial Management for the Hospitality Industry ©2007 Pearson Education, Inc. Upper Saddle River, NJ NPV of the Remarkable Hotel Project at Various Rates of Discount

Andrew, Damitio, Schmidgall Financial Management for the Hospitality Industry ©2007 Pearson Education, Inc. Upper Saddle River, NJ NPV Profile of the Remarkable Hotel Project

Andrew, Damitio, Schmidgall Financial Management for the Hospitality Industry ©2007 Pearson Education, Inc. Upper Saddle River, NJ Using the IRR for Valuation Decisions Equity approach: the IRR that you have calculated is the project’s ROE. Recall that the discount rate we used in the equity approach is k E, the owner’s required rate of return. (IRR=ROE)>k E implies NPV >0 (IRR=ROE)=k E implies NPV =0 (IRR=ROE)<k E implies NPV <0

Andrew, Damitio, Schmidgall Financial Management for the Hospitality Industry ©2007 Pearson Education, Inc. Upper Saddle River, NJ Using the IRR for Valuation Decisions (cont’d)  WACC approach: the IRR that you have calculated is the project’s ROA.  Recall that the discount rate we used in the equity approach is k A, the weighted average cost of capital  If the project generates an ROA greater than k A, value is created (NPV > 0) and the project should be accepted.  If the project generates an ROA equal to k A, value is neither created nor destroyed (NPV = 0) and we will be indifferent about accepting the project.  If the project generates an ROA less than k A, value is destroyed (NPV < 0) and the project should be rejected.

Andrew, Damitio, Schmidgall Financial Management for the Hospitality Industry ©2007 Pearson Education, Inc. Upper Saddle River, NJ It is possible to have NPV profiles that never cross the horizontal axis (and thus there is no IRR) or cross the horizontal axis more than once (and thus there are multiple IRRs) Potential Problems with the IRR

Andrew, Damitio, Schmidgall Financial Management for the Hospitality Industry ©2007 Pearson Education, Inc. Upper Saddle River, NJ Potential Problems with the IRR Mutually Exclusive Projects Scale Problem:  Maximizing the dollars of value created makes more sense than maximizing the rate of return, since ultimately it is dollars of value created that benefit hospitality firm owners. Reinvestment rate assumption problem:  The way in which the IRR is calculated implicitly assumes that the cash flows that a hospitality project generates are reinvested to earn the project’s IRR.* This may or may not be true.  Because the IRR is often higher than k A (or k E ), the assumption that a project’s cash flows can be reinvested at the IRR will often bias the IRR criterion in favor of investment alternatives with large cash flows in the short run as opposed to alternatives which generate larger cash flows later in the project’s life.

Andrew, Damitio, Schmidgall Financial Management for the Hospitality Industry ©2007 Pearson Education, Inc. Upper Saddle River, NJ Example

Andrew, Damitio, Schmidgall Financial Management for the Hospitality Industry ©2007 Pearson Education, Inc. Upper Saddle River, NJ Payback YearCash FlowTotal 1$40,500$40,500 2$53,000$93,500 3$57,600$151,100 The payback would be two years plus 6,500/57,600 of the third year, or 2.11 years. Based on an acceptance criterion of three years or less, the payback technique suggests that the project should be accepted.

Andrew, Damitio, Schmidgall Financial Management for the Hospitality Industry ©2007 Pearson Education, Inc. Upper Saddle River, NJ Internal Rate of Return $100,000 = $40,500(PV n=1,IRR ) + $53,000(PV n=2,IRR ) + 57,600 (PV n=3,IRR ) + $70,800 (PV n=4IRR ) + $73,500 (PV n=5,IRR ) CellAB 1NCFO NCF NCF NCF NCF NCF IRR Excel Formula =IRR (B1:B6) The IRR of this project comes out to be 44.7%. Since the kA for the project is 16%, the project, on the basis of the IRR criterion, is value creating.

Andrew, Damitio, Schmidgall Financial Management for the Hospitality Industry ©2007 Pearson Education, Inc. Upper Saddle River, NJ Net Present Value Using a k A of 16%, the NPV of the project would be calculated as follows: n NPV =∑ OCF t - I 0 t=1(1 + kA)t = $40,500(.8621) + $53,000(.7432) + $57,600(.6407) + $70,800(.5523) + 73,$73,500(.4761) - $100,000 =$85,300 In Excel: =NPV(.16,40500,53000,57600,70800,73500)

Andrew, Damitio, Schmidgall Financial Management for the Hospitality Industry ©2007 Pearson Education, Inc. Upper Saddle River, NJ Additional Project Valuation Criteria Equivalent annual cash flows, which is a technique useful when evaluating project alternatives with unequal lives Profitability index, which is useful when the hospitality firm is subject to capital rationing

Andrew, Damitio, Schmidgall Financial Management for the Hospitality Industry ©2007 Pearson Education, Inc. Upper Saddle River, NJ Summary  We know that NPV measures the dollars of value created by a project or investment. When we use NPV as an investment criterion, we are assured that we will select projects in the best interests of our owners.  One of these alternative investment criteria is the accounting rate of return. Accounting rates of return are easy to calculate, but they ignore the time value of money and are often calculated using accounting values instead of cash flows.  Another investment criterion is the payback period. The payback period refers to the amount of time (usually in years) that a project or investment takes to generate cash flows equal to the investment in the project. While easy to calculate, the payback period ignores both the time value of money and any cash flows that occur after the payback period.  The internal rate of return (IRR) criterion is an alternate investment criterion that does take into account the time value of money and all project cash flows. It is defined as the rate of return that makes the project’s NPV equal to zero. For single projects, the IRR criterion will usually lead to decisions consistent with NPV (unless the project has multiple IRRs). For mutually exclusive project alternatives, the IRR criterion can be inconsistent with NPV